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Monday, April 1, 2013

Building blocks

Price action trading has so many angles and components that it can be overwhelming. An average trader is unlikely to be able to recall every single aspect of price action and make the correct call most of the time. In contrast to simpler indicator based approach where everything boils down to a buy/sell, price action concepts reflect the complexity of the market and the trader needs to weigh opposing readings and make the right call.

To be able to absorb and build up one's knowledge and expertise and then practice and apply it in daily trading is no simple matter. To do it with every single bit of price action knowledge is next to impossible.

I believe that the layers of knowledge and expertise need to be built up one by one. The first and foremost is directional correctness. The next is the right entry and the last is a target estimate.

Directional Correctness: A new trader should trade not with profit in mind but with the desire to hone his directional correctness. If a trader is able to take trades that eventually move in the direction of your trade, then they could theoretically be profitable with larger stops. A simple way to do this is to not bet on any reversal attempts. Instead let the reversal attempt actually succeed (take out a swing point) and then take the next pullback. With-trend entries enable directional correctness. The market needs to be trending (higher highs/lows or lower lows/highs) and not in a chop. A simple way to ensure that you are entering with-trend is to always draw a trendline and ensure there has never been a trendline break (a sustained move beyond the trendline) or the trend has otherwise terminated (no HH/HL or LL/LH).

The right entry: A second requirement is to only enter at support. A test of the trendline or ema or HLC of the prior day are usually good choices for entry. A good location ensures that many more traders enter with you increasing the probability of success. Two or three legged pullbacks have higher probability than a one legged pullback. The earlier the pullback, the weaker it can be, i.e., the first pullback can be one-legged with a poor bar if its deep. The second and subsequent pullbacks should be two legs and deep and should preferably have a good signal bar. Do not be tempted by one-legged shallow pullbacks after the first pullback. They are likely to fail and give a two-legged deep pullback. If you find that you are often stopped out and the price eventually moves in your direction, you need to develop patience and let the market develop better entries. Once you have mastered this for normal trends, you can make adjustment for hard and soft-trends. You would still need to be cautious after an extended move or third pushes since a retrace would need to be two or three legs.

A good way to distill the points above is to reduce them to location, pattern and bar. A good location is a pullback to a support in a trend move. A good pattern is a deep pullback, preferably two or three legged. A good bar is a strong close, non-overlapped signal bar (with adjustments for 2BR, oio, etc., where you would treat the entire pattern as one bar).

Estimating targets: Once you have mastered directional correctness and are generally successful taking the right entries, you can work on maximizing your profits. The most obvious choices are measured moves of a trading range and overshoot of TCL on third push. You should also look to exit near the recent extreme once a trend is broken.

Remember the order of mastery and take them up one by one. Until you have mastered directional correctness, your mind does not have the bandwidth to absorb the intricacies of the right pattern and entry. Until you can confidently take the right entry without fear of being stopped out, you will have no conviction to hold until your estimated target.

Once you have all the three, you have developed a framework into which other observations of the market fall naturally into place. After this point, your trading style develops sophistication and absorbs information from the market and other participants naturally.